1031 Exchange Tax Deferred Benefits Are Hard to Ignore
Since the residential real estate market in the Bay Area has softened, you consider selling your rental property to buy this shopping strip. You estimate that you would have to pay about 0K in federal and state income taxes on 0K of capital gain (M less 0K purchase price and selling fees, plus K in depreciation recapture). You just hate having to pay 0K to the government – money that may go toward your down payment on the shopping strip. There is a better way – a way to defer the income tax.
First, your beneficiaries that receive your tax-deferred accounts will be subject to making at least RMDs for their remaining life expectancy at your death. Those RMDs or any more money withdrawn each year will be taxed at your beneficiary’s highest tax bracket rate since he’ll probably have a working income too. So, if you use much or all of your tax-deferred funds before you die, then you’re leaving less tax liability for him since your remaining taxable accounts (with their tax basis and lower taxation rates) hold less tax liability to him.
Those savvy about 1031s can start thinking creatively. For instance, one way to ensure that you see your college-attending child from time-time is to purchase a property in the college town and hold it as a rental, and do a 1031 exchange after graduation.
Getting tired of collecting rent and watching your residential investment property deteriorate from uncaring tenants? Are you afraid to sell after making such huge gains in the market? 1031 exchange will allow you to exchange a residential property for a business, or office rentals with a better paying clientele.
This decision to upgrade into higher quality properties with greater cash flow can occur faster now that taxes are a lower priority transaction decision. In some markets the real estate values can get ahead of the available cash flow available from the property. In these situations it may make sense to lock in your gain and look to re-invest in another property where you can achieve higher cash flow returns.
Let’s take the 401k. You are putting money into the plan before you pay taxes. When you start accessing the cash, that’s when you pay the taxes that you had postponed. So, with these investments, you are not saving taxes, you are just postponing the inevitable. When was the last time procrastination was considered a good thing?
Many early retirees find themselves saddled with a 10% penalty or stuck paying a hefty tax when they opt to take all their money out as a lump sum at retirement. If you worry about the safety of your money and take advantage of every protection plan at your disposal, then you may feel uneasy that the FDIC doesn’t cover tax deferred annuities, leaving you to pay for separate protection.
So how did this all come about – what is the history of the tax-deferred exchange?
The tax-deferred exchange actually has a rather long and complicated history dating back to 1921. The first income tax code was adopted in 1918 as part of The Revenue Act of 1918, but it did not provide for any type of tax-deferred exchange. The first tax-deferred exchange was authorized as part of The Revenue Act of 1921 when the United States Congress created Section 2021 of the Internal Revenue Code. Between 1921 and 1970, exchanges were always simultaneous swaps between two parties, by the way.
It is best to understand the concept of annuity tax deferral with a few examples. A fixed annuity sounds very similar to a certificate of deposit (CD). A certificate of deposit also has a fixed rate of return, a specified contract length, and a penalty for early withdrawal. The main difference is the tax deferred treatment of the annuity. A CD would need to be held inside a retirement account, such as an IRA, to match the tax treatment of a fixed annuity.
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